Do We Need a Social Welfare State?

One must evalulate all the trade-offs.

The following article in today’s NY Times asks the provocative question of whether we can afford a major shift to a social welfare state. One must also ask if the USA needs such a level of social welfare spending and what trade-offs it might impose. This is a question that must be answered through the democratic political process because the economic trade-offs are real.

See comments in RED.

Can America Afford to Become a Major Social Welfare State?

By N. Gregory Mankiw

September 15, 2021

In the reconciliation package now being debated in Washington, President Biden and many congressional Democrats aim to expand the size and scope of government substantially. Americans should be wary of their plans — not only because of the sizable budgetary cost, but also because of the broader risks to economic prosperity.

The details of the ambitious $3.5 trillion social spending bill are still being discussed, so it is unclear what it will end up including. In many ways, it seems like a grab bag of initiatives assembled from the progressive wish list. And it may be bigger than it sounds: Reports suggest that some provisions will arbitrarily lapse before the end of the 10-year budget window to reduce the bill’s ostensible size, even though lawmakers hope to extend those policies at a later date.

People of all ages are in line to get something: government-funded pre-K for 3- and 4-year-olds, expanded child credits for families with children, two years of tuition-free community college, increased Pell grants for other college students, enhanced health insurance subsidies, paid family and medical leave, and expansions in Medicare for older Americans. A recent Times headline aptly described the plan’s coverage as “cradle to grave.”

If there is a common theme, it is that when you need a helping hand, the government will be there for you. It aims to assist people who are struggling in our rough-and-tumble market economy. On its face, that instinct doesn’t sound bad. Many Western European nations have more generous social safety nets than the United States. The Biden plan takes a big step in that direction.

Can the United States afford to embrace a larger welfare state? From a narrow budgetary standpoint, the answer is yes. But the policy also raises larger questions about American values and aspirations, and about what kind of nation we want to be.

The issue Prof. Mankiw addresses here is the question as to whether the costs of such programs yield the benefits desired. There is a lot of talk on the left that Modern Monetary Theory demonstrates that deficits don’t constrain government spending so that politicians should spend what’s needed to achieve whatever objective they choose. This is a bit of wishful fantasy. What matters economically and financially is whether such spending yields a greater return in terms of freedom and quality of life for society as a whole. If such spending merely increases the deficit but does not invest in the productivity of the economy, then it is a dead weight upon society. It’s not much different than one’s personal desire to choose between buying a new car or instead investing in education. One must compare how each choice will yield in terms of financial freedom and happiness over the longer term.

The Biden administration has promised to pay for the entire plan with higher taxes on corporations and the very wealthy. But there’s good reason to doubt that claim. Budget experts, such as Maya MacGuineas, president of the Committee for a Responsible Federal Budget, are skeptical that the government can raise enough tax revenue from the wealthy to finance Mr. Biden’s ambitious agenda.

The United States could do what Western Europe does — impose higher taxes on everyone. Most countries use a value-added tax, a form of a national sales tax, to raise a lot of revenue efficiently. If Americans really want larger government, we will have to pay for it, and a VAT could be the best way.

The costs of an expanded welfare state, however, extend beyond those reported in the budget. There are also broader economic effects.

Arthur Okun, the former economic adviser to President Lyndon Johnson, addressed this timeless issue in his 1975 book, “Equality and Efficiency: The Big Tradeoff.” According to Mr. Okun, policymakers want to maximize the economic pie while slicing it equally. But these goals often conflict. As policymakers attempt to rectify the market’s outcome by equalizing the slices, the pie tends to shrink.

Mr. Okun explains the trade-off with a metaphor: Providing a social safety net is like using a leaky bucket to redistribute water among people with different amounts. While bringing water to the thirstiest may be noble, it is also costly as some water is lost in transit. 

In the real world, this leakage occurs because higher taxes distort incentives and impede economic growth. And those taxes aren’t just the explicit ones that finance benefits such as public education or health care. They also include implicit taxes baked into the benefits themselves. If these benefits decline when your income rises, people are discouraged from working. This implicit tax distorts incentives just as explicit taxes do. That doesn’t mean there is no point in trying to help those in need, but it does require being mindful of the downsides of doing so.

Yes, we must reconcile the trade-off, but I would also characterize it as freedom and liberty to pursue one’s personal happiness versus the promise of individual economic security promised by the collective. The fulfillment of that promise is often costlier than anticipated and the benefits disappointing.

Which brings us back to Western Europe. Compared with the United States, G.D.P. per person in 2019 was 14 percent lower in Germany, 24 percent lower in France and 26 percent lower in the United Kingdom.

Economists disagree about why European nations are less prosperous than the United States. But a leading hypothesis, advanced by Edward Prescott, a Nobel laureate, in 2003, is that Europeans work less than Americans because they face higher taxes to finance a more generous social safety net.

In other words, most European nations use that leaky bucket more than the United States does and experience greater leakage, resulting in lower incomes. By aiming for more compassionate economies, they have created less prosperous ones. Americans should be careful to avoid that fate.

The point of course, is not that leisure time is undesirable but that people can choose how they invest their time and energy, rather than have state policy reward or penalize that choice arbitrarily. In a free and just society, this choice should be left to the individual. Liberty and security are not mutually exclusive goals.

Compassion is a virtue, but so is respect for those who are talented, hardworking and successful. Most Americans descended from immigrants, who left their homelands to find freedom and forge their own destinies. Because of this history, we are more individualistic than Europeans, and our policies rightly reflect that cultural difference.

That is not to say that the United States has already struck the right balance between compassion and prosperity. It is a continuing tragedy that children are more likely to live in poverty than the overall population. That’s why my favorite provision in the Biden plan is the expanded child credit, which would reduce childhood poverty. (I am also sympathetic to policies aimed at climate change, which is an entirely different problem. Sadly, the Biden plan misses the opportunity to embrace the best solution — a carbon tax.)

But the entire $3.5 trillion package is too big and too risky. The wiser course is to take more incremental steps rather than to try to remake the economy in one fell swoop.

Actually, I would suggest that the choice between liberty and security is a false one and the assumption that security can only be secured for the individual by the state to also be false. The leftist assumption is that the state has to intervene to redistribute wealth after the fact when instead we can design policies that empower citizens to join in the distribution of that wealth by participating in the risk-taking venture before the fact. Then the distribution of resources in society will mostly take care of itself. As it is now, and with this social welfare expansion, we prevent most individuals who need to participate from participating, forcing them to depend on the largesse of the state or the dictates of the market. This is hardly optimal in the search for liberty and justice. In light of my preference to preserve my liberty and take care of my own security, my answer to Prof. Mankiw’s question would be NO.

N. Gregory Mankiw is a professor of economics at Harvard. He was the chairman of the Council of Economic Advisers under President George W. Bush from 2003 to 2005.

House of Cards: Truth Stranger Than Fiction

As a political economist and policy analyst I have to say I’ve found the NetFlix series, House of Cards very entertaining. Of course, it is over the top with political sleaze and corruption, something that probably syncs well with the public’s impression of Washington politics these days. (I find it interesting that the writers chose to designate the depraved, murderous POTUS Frank Underwood, played by Kevin Spacey, as a big “D” Democrat. With an annoyingly ambitious, self-righteous wife as co-president – sound familiar? Apparently, depravity with good intentions is somewhat acceptable these days in partisan circles, with Underwood often turning to the audience to explain the bare facts of Machiavellian realpolitik. How unfortunate for poor Niccolo, who was a true republican patriot, but recast by history as the apologist for a ruthless, depraved Prince.)

I have been most amused by Season 3, where Pres. Underwood proposes a massive jobs program paid for by slashing entitlements. This is just too juicy to let pass unnoticed. Let’s translate this “promise” of a full employment Nirvana: “I’m going to take your hard earned money we extorted through Social Security and Medicare taxes and give it away to companies that will employ workers for jobs that the productive private economy will not create because they lose money. Isn’t that grand? We’ll all feel better about humanity, even though we’ll be poorer for it (all except me, that is).”

The irony is that this absurd fiction is actually proposed too often as serious politics in the real Washington D.C. Quite a few other bloggers have explained the surrealness of a POTUS creating jobs from whole cloth just because he can command it from the White House. The numbers just don’t add up. But I was struck more by the widely accepted premise that asserts “jobs” as the end-all of what ails a society of free citizens. The Underwood character actually says, “People are dying from unemployment!” This cuts pretty close to home with Obama recently claiming that “chanting ‘Death to America’ does not create jobs.” Really? Is that what they’re beheading innocents over, a few good jobs?

People don’t die from unemployment, they die from poverty, deprivation, and disease. They die from oppression and violence. Unproductive jobs subsidized by governments do not alleviate poverty, they merely spread poverty around. The thing is, politicians focus on jobs because that is the only way they know how to spread the benefits of capitalism around the population. But we are moving into a new age that departs from the skilled labor-intensive manufacturing of the post-WWII years. Our financial policies have accelerated this trend away from labor by providing cheap capital to take advantage of cheaper labor overseas or machine/robot substitution. We are entering the information, artificial intelligence, and robotics age, and yet our politicians are still making false promises of a job and two chickens in every pot. Not going to happen. We need to think outside that box to discover how we are going to create and share wealth in the new economy. There are many alternative ways to participate in a market economy than solely as a labor input.

In the meantime, enjoy the entertainment. It’s hilarious. But don’t expect a job from America Works.

A Medical Doctor Weighs in on Health Care


This is a good quote speaking to the rationality of good health care as being based on the relationship between doctor and patient. Mark Sklar writing in the WSJ:

The patient should be the arbiter of the physician’s quality of care. Contrary to what our government may believe, the average American has the intellectual capacity to judge. To give people more control of their medical choices, we should move away from third-party payment. It may be more prudent to offer the public a high-deductible insurance plan with a tax-deductible medical savings account that people could use until the insurance deductible is reached. Members of the public thus would be spending their own health-care dollars and have an incentive to shop around for better value. This would encourage competition among providers and ultimately lower health-care costs.

By contrast, the Affordable Care Act’s plans for establishing “medical homes”—a team-based health-care delivery model—and accountability-care organizations will only add more bureaucracy and enrich the consultants and companies organizing these entities.

To improve quality, we need to unchain health-care providers from the bureaucracies that are strangling them fiscally and temporally. We can better control medical costs if we strengthen physicians’ relationships with their patients rather than with their computers.

A True Healthcare Market?


There are many small fixes that can help repair the market for healthcare and health insurance – a market that has been seriously distorted for the past 30+ years. This article hits on the basic principle that catastrophes need a functioning insurance market based on actuarial probabilities, but healthcare maintenance is something we all need to SAVE for. Health savings accounts are a necessary component that the ACA attempts to excise. Why?

From Barron’s:

Unmanaged Competition


Making health care into a real economy

A reader recently asked, “If the Affordable Care Act isn’t the answer, what is?” Another asked, “Do you really want a health-insurance system without government regulation?” These are fair questions. We have found problems with the new health-care law—both operational and philosophical—to be so compelling that even the status quo ante seems preferable, but we also have a better vision.

Neither a benevolent dictator nor an army of bureaucrats can create an ideal system that serves all possible buyers of health care and properly rewards all who provide it. Only independent individuals can operate in a market, deciding what to buy and what to sell, finding prices that clear the market.

But a market cannot work when third parties stand over the supplier and the customer to fix prices or supplies. So the first element of a good U.S. health-care system must be that all Americans must purchase their own health-insurance policy.

Unlike Obamacare, this mandate should leave lots of room for competition and choice.

Limited Choice

Nearly all health care in the U.S. is paid for by third parties—government, employers, insurance companies—who have neither the provider’s nor the customer’s interests at heart. Individual choice is deliberately limited for the convenience of the real payers.

So the second element of a good U.S. health-care system must be that the citizens must make choices for themselves. Price and scope of coverage are the consumers’ business, not their government’s.

Health insurance is too complicated to be left to policy makers, and if we have a real market, the business will be even more complicated because every insurance company—and new ones—will create more policies tailored to the consumers’ various preferences. In a free market for health insurance, we will have at least as many different styles of health insurance as there are flavors and prices of canned soup in the supermarket.

Insurance, like banking and other potential Ponzi schemes, does need government auditing and supervision, to ensure soundness but not to limit variety.

The current U.S. health-care system is parsimonious. Americans are fearfully aware that their health-insurance coverage may have holes and that they won’t know where the holes are until it’s too late. Some procedures may be excluded from coverage; some health-care providers won’t accept certain types of insurance. Hospitals and doctors do not compete on price; many don’t disclose their inflated official prices, except on the bills; few if any disclose the discounts they offer to the real payers.

Many doctors refuse to accept patients covered by the two biggest government programs, Medicare and Medicaid, both of which have arcane systems for setting what they will pay, regardless of providers’ billed prices.

On the other hand, the U.S. health-care system is not just parsimonious; it is also notoriously wasteful. Insurers, including the government Medicare plan, carefully define what services they will pay for and arrange with providers how much they will pay, but they do almost nothing to limit the number of allowable services they will pay for. Providers living under price fixing make it up on volume.

Plentiful Funds

We often hear that the health-care industry constitutes one-sixth of the U.S. economy, heading for 25% of the economy as the population ages. Less frequently are we reminded that the federal government’s taxpayers and lenders are already paying for half of health-care expenditures. Almost never does anyone note that the federal government’s per capita expenditures on health care for about half its citizens are enough to run a universal health-care system like that in the United Kingdom.

We should not want a government care system filled with problems like the U.K. system; the point is that the current U.S. health-care system already has more than enough money sloshing around to provide excellent care for all Americans.

So the third element of a good U.S. health-care system is to subject health-care to the discipline of consumer discretion.

David Goldhill, CEO of GSN, the cable-TV-network company, is the author of a terrific recent book on the American system: Catastrophic Care: How American Health Care Killed My Father—And How We Can Fix It. Most of the book is devoted to the ills of the current system, which Goldhill sums up as, “All of us are spending insane amounts of money, yet the system makes us feel like paupers.” The health-care industry has hardly any accountability to the customer, and thus it offers terrible service, high prices, limitations on supply of doctors and hospitals, excessive errors, underinvestment in information technology, and lack of coordinated care.

Readers will be encouraged to jettison the current payment systems and the current payers, perhaps to take up these reforms:

Market Power
  1. Employers should not be allowed to provide health insurance, and the federal government should provide direct subsidies only for low-income consumers.
  2. High-deductible catastrophic insurance should be encouraged, not limited. That would lower premiums so that citizens could create Medical Savings Accounts for most of their routine care. Those too poor for this system should receive government subsidies for their insurance premiums and their savings deposits, putting them on the same footing as other citizens when they choose their providers of health care and health insurance.
  3. Medical underwriting should be encouraged, not outlawed, with those who are uninsurable participating in assigned-risk pools subsidized by the federal government.
  4. There could also be a direct subsidy to providers, by which the government would pay a percentage of every bill for every payer with income less than the median income. The share should be significant but not so large that patients would lose their price sensitivity and their incentive to shop.

The essence of our health-care system has been to confuse everyone into thinking they have control without paying for it. In health care as in other things, if we pay for what we get, we may get what we pay for.

Debt Bomb


Hoping to receive those promised government benefits? This is why entitlement reform is the real controversy behind the political theater of debt ceiling and budget battles.

From the WSJ:

Is America Really $17 Trillion in Debt?

By James Freeman
Recent headlines say that President Obama succeeded in breaking the debt limit to allow federal borrowing beyond $17 trillion. But Stanley Druckenmiller, one of the most successful money managers of all time, says “there’s just one little problem” with Washington’s math. “Everyone’s running around saying the debt is $17 trillion,” notes Mr. Druckenmiller. But the government can acknowledge that titanic burden on future generations only by ignoring even larger obligations.“If you borrow money from an individual with the agreement to pay them back in benefit payments in Social Security and Medicare after the age of 65, in their brilliance the United States accounting experts call that revenues,” says Mr. Druckenmiller. “But in any corporation in America—other than maybe Enron—if you borrow money from someone with the agreement to pay it back in the future, that’s called a debt.” And these future commitments don’t appear on Uncle Sam’s balance sheet.

What’s the real burden when you count these promises? Taking the “alternative fiscal scenario” from the Congressional Budget Office, which still understates the problem but is the closest Washington gets to reality, Mr. Druckenmiller calculates the net present value of Beltway commitments. He concludes that “the future liabilities are $205 trillion, not 17.” It’s a staggering sum, roughly 12 times the size of the U.S. economy.

Mr. Druckenmiller notes that he’s counting up all the federal promises from here to eternity, while others prefer to focus on shorter time horizons. And to be sure, investors in U.S. Treasury debt have a legal claim to repayment whereas future retirees have only promises from politicians. But that doesn’t make the need for reform any less urgent.

Robbing Piggy Banks

Credit: William Waitzman for Barron's

Credit: William Waitzman for Barron’s

This is excerpted from an article in this week’s Barron’s Magazine:

President Obama Thinks Your IRA Is Too Big


The White House budget proposes limiting contributions to tax-deferred retirement accounts for the wealthy. The complexities are head-spinning.

When President Barack Obama released his fiscal 2014 budget in April, it included a proposal to set a cap on tax-advantaged retirement savings for wealthy individuals. In the scheme of the larger budget, let alone the partisan rancor sure to engulf any negotiations, it was small potatoes. But consternation — then uproar and outrage — followed. The failure of Americans generally to save enough for retirement is well documented, and needs no repeating. But even those people lucky enough to have built up seven-figure nest eggs are feeling squeezed by the trifecta of low interest rates, volatile markets, and increased life expectancies, which have put a big dent in how much they can withdraw each year without risking running out of cash. They felt like they were being targeted for having saved diligently and been financially successful.


It appears Mr. Obama believes this is a good way to mitigate the winner-take-all nature of success in a free society. Yes, we must do something to spread the benefits of economic success, but one can only marvel at how wrong-minded this suggested tax policy is. Retirement saving is a private good, which means you and I can choose to save just as much as we wish and there is a well-developed market of choices that meet our individual needs. People have company pensions, savings accounts, annuities, 401ks, and many other investment vehicles with which to accomplish this. On the public side we have the entitlement program of Social Security. When originated in 1935, the Social Security Act was meant to be a complementary public pension system to insure that people with inadequate savings or unfortunate financial circumstances did not suffer abject poverty. It was NEVER meant to be the sole source of retirement support for the entire population.

Private retirement savings help mitigate dependence on the Social Security trust fund and there is probably a reasonable argument to be made over raising the retirement age and means-testing. But our tax policies have deliberately tried to encourage private savings to increase national savings. This proposal endeavors to go backwards, presumably under some misguided notion of “fairness.” One must also assume that this president believes the government is the best or only vehicle to tax and redistribute the benefits of economic success. But it makes far more sense to extend the tax benefits of saving to the lower and middle income classes rather than seek to restrain the savings of the successful. For example, why limit contributions? The only reason not to do so must be some misplaced desire to increase tax revenues to grow the public sector. But the private economy has proven far more efficient in the provision of goods and services and the desire of some in Washington to increase our dependence on inefficient public goods is counter-productive to our material well-being as well as our personal freedoms. Private savings are a source of capital and one feels the need to constantly remind our political class of the meaning of “capital-ism” with pointed references to the etymology of the word.  One wonders if the thinking in Washington ever gets that far.

Managing and Mismanaging Risk

riskThis is the kind of issue that makes readers’ eyes glaze over, but it’s crucially important to understanding our financial situation today and for the future. The political management of risk through guaranteed benefits means that uncertainty risks and losses are borne by third party taxpayers. This is a highly inefficient strategy to manage risk because future outcomes are a function of present behavior. When people see there is no consequence to their present behavior, they do things that blow up the assumptions about the future. This is a form of moral hazard that renders insurance pooling ineffective and unworkable.

Social Security is a form of defined benefit plan that relies on uncertain assumptions about future growth. If we mismanage that growth, the assumptions will fall seriously short of expectations. Our Medicare entitlements follow the same logic and it’s no wonder that we see enormous moral hazard costs in the form of unsustainable deficits. The idea that raising taxes can meet this need is fallacious in its basic premises. If we mismanage risk in this way the hole we dig will only get deeper and deeper. This is the most consequential statement of fact to take from the following analysis: In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments.

From the WSJ:

The Pension Rate-of-Return Fantasy

Counting on 7.5% when Treasury bonds are paying 1.74%? That’s going to cost taxpayers billions.


It has been said that an actuary is someone who really wanted to be an accountant but didn’t have the personality for it. See who’s laughing now. Things are starting to get very interesting, actuarially-speaking.

Federal bankruptcy judge Christopher Klein ruled on April 1 that Stockton, Calif., can file for bankruptcy via Chapter 9 (Chapter 11’s ugly cousin). The ruling may start the actuarial dominoes falling across the country, because Stockton’s predicament stems from financial assumptions that are hardly restricted to one improvident California municipality.

Stockton may expose the little-known but biggest lie in global finance: pension funds’ expected rate of return. It turns out that the California Public Employees’ Retirement System, or Calpers, is Stockton’s largest creditor and is owed some $900 million. But in the likelihood that U.S. bankruptcy law trumps California pension law, Calpers might not ever be fully repaid.

So what? Calpers has $255 billion in assets to cover present and future pension obligations for its 1.6 million members. Yes, but . . . in March, Calpers Chief Actuary Alan Milligan published a report suggesting that various state employee and school pension funds are only 62%-68% funded 10 years out and only 79%-86% funded 30 years out. Mr. Milligan then proposed—and Calpers approved—raising state employer contributions to the pension fund by 50% over the next six years to return to full funding. That is money these towns and school systems don’t really have. Even with the fee raise, the goal of being fully funded is wishful thinking.

Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or “underfunded pension liabilities,” need to be made up by employers or, in the case of California, taxpayers.

In June of 2012, Calpers lowered the expected rate of return on its portfolio to 7.5% from 7.75%. Mr. Milligan suggested 7.25%. Calpers had last dropped the rate in 2004, from 8.25%. But even the 7.5% return is fiction. Wall Street would laugh if the matter weren’t so serious.

And the trouble is not just in California. Public-pension funds in Illinois use an average of 8.18% expected returns. According to the actuarial firm Millman, the 100 top U.S. public companies with defined benefit pension assets of $1.3 trillion have an average expected rate of return of 7.5%. Three of them are over 9%. (Since 2000, these assets have returned 5.6%.)

Who wouldn’t want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%. There is almost zero probability that Calpers will earn 7.5% on its $255 billion anytime soon.

The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.

So what to do? I recall a conversation from 20 years ago. I was hoping to get into the money-management business at Morgan Stanley. I wanted to ramp up its venture-capital investing in Silicon Valley, but I was waved away. It was explained to me that investors wanted instead to put billions into private equity.

One of the firm’s big clients, General Motors, had a huge problem. Its pension shortfall rose from $14 billion in 1992 to $22.4 billion in 1993. The company had to put up assets. Instead, Morgan Stanley suggested that it only had an actuarial problem. Pension money invested for an 8% return, the going expected rate at the time, would grow 10 times over the next 30 years. But money invested in “alternative assets” like private equity (and venture capital) would see expected returns of 14%-16%. At 16%, capital would grow 85 times over 30 years. Woo-hoo: problem solved. With the stroke of a pen and no new money from corporate, the GM pension could be fully funded—actuarially anyway.

Things didn’t go as planned. The fund put up $170 million in equity and borrowed another $505 million and invested in—I’m not kidding—a northern Missouri farm raising genetically engineered pigs. Meatier pork chops for all! Everything went wrong. In May 1996, the pigs defaulted on $412 million in junk debt. In a perhaps related event, General Motors entered 2012 with its global pension plans underfunded by $25.4 billion.

In other words, you can’t wish this stuff away. Over time, returns are going to be subpar and the contributions demanded from cities across California and companies across America are going to go up and more dominoes are going to fall. San Bernardino and seven other California cities may also be headed to Chapter 9. The more Chapter 9 filings, the less money Calpers receives, and the more strain on the fictional expected rate of return until the boiler bursts.

In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments. Meanwhile, though, all the knobs and levers that can be pulled to delay Armageddon have already been used. California, through Prop 30, has tapped the top 1% of taxpayers. State employers are facing 50% contribution increases. Private equity has shuffled all the mattress and rental-car companies it can. Buying out Dell is the most exciting thing they can come up with. Expected rates of return on pension portfolios are going down, not up. Even Facebook millionaires won’t make up the shortfall.

Sadly, the only thing left is to cut retiree payouts, something Judge Klein has left open. There are 12,338 retired California government workers receiving $100,000 or more in pension payments from Calpers. Michael D. Johnson, a retiree from the County of Solano, pulls in $30,920.24 per month. As more municipalities file Chapter 9, the more these kinds of retirement deals will be broken. When Wisconsin public employees protested the state government’s move to rein in pensions in 2011, the demonstrations got ugly—but that was just a hint of the torches and pitchforks likely to come.

Meanwhile, it’s business as usual. California Gov. Jerry Brown released a state budget suggesting a $29 million surplus for the fiscal year ending June 2013 and $1 billion in the next fiscal year. Actuarially anyway.

Or as Utah Rep. Jason Chaffetz told Vermont Gov. Peter Shumlin, upon learning at a 2011 House hearing about that state’s unrealistic pension assumptions: “If someone told me they expected to get an 8% to 8.5% return, I’d say they were probably smoking those maple leaves.”

Rich Dad, Poor Baby

Unless you’ve been hiding under a rock for the past decade, you know there’s a popular financial self-help book series titled Rich Dad, Poor Dad written by Robert Kiyosaki. The basic premise of the numerous books Mr. Kiyosaki has spun out can be stated in a few sentences.

Rich Dad passes on the lessons of financial success, which follow the basic dictum to work, save, borrow to invest, take prudent risks, produce, create value, and sell to accumulate tangible wealth and realize financial freedom. Poor Dad ends his lessons at working hard at a good job in order to retire comfortably and securely after a long and hopefully productive career. Poor Dad tends to borrow to bridge consumptions needs and income, in effect buying cars and homes with credit and debt.

The difference here is that Poor Dad’s wealth-creating productivity is captured by someone else, usually an employer or financier, who is taking the risks that pay his salary. In effect, the Poor Dad has traded financial freedom for security, and perhaps foregone accumulated wealth to pass on to heirs in return for future pension promises that may expire with his final breath. Mr. Kiyosaki’s insight is that too many choose Poor Dad’s strategy because they mistakenly feel they have little choice. (Rich Dad’s strategies to invest and accumulate wealth can take an infinite number of forms, but Mr. Kiyosaki’s main strategy is highly-leveraged investment real estate, a profitable strategy in the past because it’s subsidized by government tax and credit policies. Profitable, at least until everybody else tries to get in on the action and inflates prices into a “bubble.”)

The Rich Dad, Poor Dad financial formula can help illuminate the similar choices we face as a nation. From an economic perspective we see that Rich Dad produces more and consumes less of his income, while Poor Dad consumes a greater share of his income. When Poor Dad’s consumption needs outstrip his savings, he borrows against future income. In our current political vernacular, Rich Dad is the 1%, while Poor Dad is the 99% (the true ratios are probably closer to 20-80). At the level of the national economy, the relationship between these two strategies is symbiotic; in other words, the two need each other to thrive in order to survive. Their relationship is simply stated: Without consumers, producers have no market and without producers, consumers have no goods.

The problem is that as a nation, we’ve adopted Poor Dad’s financial strategy. We’ve taxed work, savings, production, investment and capital accumulation, while subsidizing debt and over-consumption. This is marked by greater dependence on government income security in the form of unfunded entitlements (Social Security, Medicare, Medicaid, Obamacare) and the explosion of debt to manage inadequate present consumption demand by borrowing it from the future. The interest on those trillion dollar deficits and $16+ trillion dollar debt will have to be serviced by future tax dollars that will reduce future consumption demand. In effect, the wannabe Rich Dads (and Moms) of today are pushing the burden of unfunded entitlements and debt off on future generations, or the Poor Babies.

One might be tempted to make partisan political hay out of this shameful fact, but both parties and all voters are complicit in the national scam. One party spouts empty rhetoric about ending the tax and spending regime but does little, while the other party puts the pedal to the metal to gain votes. The big government, pro-entitlement pushers expect that future generations will see the wisdom of paying higher taxes and settling for less in order to pay for cradle-to-grave security, but there’s good reason to question this assumption. It seems to directly contradict the technology trend toward greater autonomy and freedom of choice that younger generations have come to take for granted. One thing is for sure, greater dependency on social entitlements must come at the cost of less personal autonomy and freedom of choice. In other words, less freedom. This was not supposed to be Rich Dad’s legacy.

Change, Chance, and Politics

We live in a world that can be scientifically (and poetically) described as uncertain, probabilistic, and risky. Politics is defined as the “art of governing,” in other words, managing the affairs of the citizenry. This definition implies the imperative of setting social priorities and making social choices. So, to complete the big picture, we have a landscape that is uncertain, probabilistic and risky, and on that landscape we live in human societies that collectively try to manage their survival as the landscape constantly changes through time. This is how we should conceptualize the political.

This essay is not about the method of social choice, such as voting and various theories of government such as democracy or autocracy, but about the goals of politics given the uncertain state of the world. At the turn of the 15th century, Niccolo Machiavelli, who spent considerable time contemplating politics, surmised that our fate was determined by two factors, in about equal parts: one’s virtù (or character), and pure random chance. A successful “prince,” or political leader, was one who possessed noble virtù, but who was also able to adapt to the changing times. In modern terms, we interpret this to mean successful politics is promoted by institutions that are rooted in timeless principles of human nature, but are flexible enough to adapt to changing conditions. Sometime around the 19th century, science came to accept this idea that the world was not deterministic, but probabilistic. Kings became kings not because of ancestral claims or divine right, but due to a series of random historical events. Governments designed by the people were products of their constitutions, nothing more.

It’s odd that more than a half a millennium after Machiavelli’s insight and more than a century after science’s confirmation, many people adopt a governing philosophy, unwittingly perhaps, that assumes government policy is deterministic, rather than probabilistic and uncertain. Such people believe that if the government passes a law, the outcome is a given. If the government doubles taxes, then revenues naturally double. Of course, if laws were deterministic, we would have no need of courts, judges, or juries, but such inconveniences are easily overlooked or dismissed by believers of a deterministic world.

The salient point here is that the ‘government,’ as a collection of fallible and self-interested human beings, cannot really ‘manage’ the economy. It cannot manage global climate change. It cannot manage its citizens’ political preferences. What it can do, quite unintentionally, is mismanage it all. But we do need functioning institutions to manage social choice, so we stumble along with the best we have, which in our case is some form of participatory democracy. But the governing function of ‘managing change’ is severely limited. The best the government can do is help its citizens to manage the uncertainties of change.

This is not as intangible as it sounds. We have all been blessed by nature with a keen sense of how to survive by managing the risks we face in an uncertain world, as have all living species. Nothing has changed that much in a few million years. Nature manages the risks of change and random chance through biological diversification. We also diversify our risks by pooling them with others for mutual protection. I would guess that this was one of the primary motivations for creating tribes, communities, cities, and nation-states in the first place (the other being our innate sociability).

At this point we should make the connection to modern politics and democratic government. Pooling through diversification is merely a definition of insurance, such as what you buy for your car or your house. And social insurance describes the logic of entitlement programs, such as Medicare and Social Security. Bismarck is credited with introducing the first examples of state-managed social insurance in Germany in the late 19th century. More than a century later, social insurance entitlements make up the largest share of government budgets in all advanced democracies. Should we assume that this demonstrates the best government can do is provide cradle-to-grave social insurance to manage the vicissitudes of an uncertain world? On the contrary.

There is a cost to insurance that sometimes outweighs its benefits. The primary cost is called moral hazard. Insurance can cause people to assume excessive risks. The common example is a driver who drives more recklessly because he has insurance, imposing more costs on the insurance company than they receive in premiums. Another case with social insurance is that Social Security causes people to reduce saving for their retirement, making them more dependent on the program than they would be otherwise. These moral hazard problems show up with deteriorating financials for the pool – in the private case the insurance company would go out of business, in the public case we get ever-increasing deficits in the programs. (Social Security and Medicare are not true social insurance pools, but inter-generational transfer programs—this creates another whole set of problems.) Either way, the pool will eventually fail. Private insurance avoids this fate by monitoring the behavior of its participants and pricing accordingly (i.e., a speeding ticket results in an premium increase). But social insurance, as part of a social compact, cannot discriminate between risky and prudent behavior, so the good risks end up subsidizing bad risks and the bad risk pool grows. In other words, if you get subsidized healthcare, why eat well and exercise? Why not just indulge? Somebody else will pay for it. And that’s what we do and the deficits grow. (Politicians also increase benefits without increasing tax contributions in order to win votes for re-election. This would be like an insurance company approving all claims no matter how frivolous and never raising premiums, kind of like Santa Claus. The company would be out of business rather quickly.)

So, private insurance is always more efficient, cheaper, and more abundant than social insurance. This implies that the government should do what it can to assure a functioning, competitive private insurance industry. Our government has failed us in this regard by hampering competitiveness and fostering monopolies. More importantly, the most efficient form of insurance that avoids all moral hazard costs is self-insurance. We self-insure when we save for a rainy day. We can design tax and regulatory policies that empower self-insurance across the population by allowing for private asset accumulation and diversification. (This essentially is what insurance companies do with your premiums in order to make a profit.) Why can we not have tax-free accounts set up for healthcare costs, educational costs, retirement, and even first time housing purchases? Then we could assume most of our own economic burdens in life that currently flow unnecessarily and inefficiently through the government. Self-insurance also fosters a competitive market in the goods and services we need by creating a discriminating consumer market. Our politicians have made such private alternatives overly restrictive and over-regulated instead of making them more available.

Social insurance, private insurance, and self-insurance are all complementary means to managing the risks of change in an uncertain world. Social insurance must be the last resort when private markets fail, but we should never allow social insurance to drive out the more efficient alternatives offered by a thriving private economy. That is how a free society and a free people will best ‘manage its affairs,’ in a world of constant change and uncertainty.

Reality Check

We could accomplish entitlement reform by design, but, because of our political dysfunction, we’ll get it by default. Unfortunately, the last election showed that it’s probably still too early for a reality check.

From the WSJ:

None Dare Call It Default

A nicer term for what’s about to sock the middle class is ‘entitlement reform.’


To call Greece First World may be a stretch, but Greece has defaulted once already, and it is only a matter of time until Greece defaults again. Welcome to default-o-rama, the next chapter in the First World’s struggle for fiscal sustainability.

Japan is piling up debt in the manner of a nation beyond hope. France, Belgium, Spain and Italy are defaults waiting to happen unless Europe can somehow generate the kind of growth that has eluded it for decades.

America’s fiscal cliff is an artificial crisis. We have no trouble borrowing in the short term. But at some point the market will demand evidence that long-term balance is being restored. President Obama said in his first post-election press conference that he doesn’t want any proposals that “sock it to the middle class.” He knows better. A long-term socking is exactly what’s coming to the middle class, which must pay for the benefits it consumes.

A few years ago, when the economy was humming, a common estimate held that federal taxes would have to rise 50% immediately to fully fund entitlement programs. Today, a 50% tax increase would be needed just to meet the government’s current spending, never mind its future obligations.

One way or another, then, entitlements will be cut. Don’t call it default. The correct term is entitlement reform.

You saw this day coming and saved for your own retirement. Don’t call it default when Washington inevitably confiscates some of your savings, say, by raising taxes on dividends and capital gains. Taxpayers accept the risk of future tax hikes that may make the decision to save seem foolish in retrospect.

According to economists Robert Novy-Marx and Josh Rauh, state and local taxes would have to increase by $1,385 per household immediately to make good the pension promises to state and local workers, including firefighters and cops. That’s not going to happen given all the other demands on taxpayers. Default, in this case, is the proper word for cities and states using bankruptcy to repudiate their pension obligations.

Prominent voices ask why the Treasury shouldn’t just cancel the government bonds the Federal Reserve has been buying. It’s money one part of the government owes the other. Dispensed with, of course, would be the idea that the Fed, in buying these bonds in the first place, was engaged in monetary policy. The Fed was printing money so Washington could spend it.

Now let it be said that inflation isn’t fundamentally a solution to the entitlement problem, but the Federal Reserve is being led by increments to accommodate inflationary financing of future deficits. Don’t call it default. Inflation is a risk savers are deemed to have accepted by putting their faith in the U.S. dollar.

Here’s what you weren’t told about Medicare during the presidential debates. Under the Paul Ryan plan, the affluent would pay more. Under the Obama plan, the affluent would flee Medicare to escape the waiting lists, shortages and deteriorating quality as Washington economizes by ratcheting down reimbursements to doctors and hospitals. Don’t call either default. You don’t have a legally enforceable right to the free care you imagined you were promised.

“Don’t worry” was President Obama’s implicit message during the campaign: If cutting subsidies for Big Bird is unthinkable, a joke, how much more so cutting benefits for middle-class voters?

Don’t go running to a judge when this doesn’t pan out. The courts do not overrule changes in government policy just because citizens find their promised free lunch isn’t forthcoming. Nor will it be fruitful to appeal to politicians’ sense of “fairness.” Politicians can be relied on to do what will get them re-elected. And, believe it or not, that is the good news.

If politicians weren’t eager to be re-elected, the trust necessary to be an investor would vanish altogether. While there is no escaping our challenges, there is a path in which the economy grows strongly and we don’t savage each other, and there is the other path. For years the trustees of Social Security and Medicare were accused of exaggerating the programs’ deficits by envisioning that America’s long-run growth would become more like Europe’s. Now who doesn’t fret that America’s growth is becoming permanently slower like Europe’s?

Which brings us to President Obama. He knows cuts are necessary but seeks to position Democrats politically as the defender of all spending. Notice that, with ObamaCare, he is deliberately creating a constituency of the young to set against the old in future fights over the allocation of federal health care dollars.

Meanwhile, saving the dynamism of the U.S. economy, while still affording an entitlement state, naturally falls to the other party in a two-party system.